24/08/2024 Market Analysis

Week Ahead: Fed Easing Expectations & Currency Shifts

In the middle of last week, the Fed funds futures discounted 103 basis points of cuts for this year. After some movement following Fed Chair Powell’s remarks, the market finished the week with 104 basis points of cuts priced into the Fed funds futures curve. The two-year note yield settled at a three-week low, and the dollar slumped. The Dollar Index lost 1.7% last week, marking its fifth consecutive drop and the largest weekly decline of the year. Although the euro rose to $1.12, its highest level since July 2023, and sterling appreciated to $1.3230, its best level since March 2022, they were not the primary drivers of the greenback’s retreat. Instead, the New Zealand dollar led the charge with a ~2.85% gain. The swaps market now fully discounts three rate cuts for some central banks for the remainder of the year.

In the coming week, the key data points include the Fed’s preferred inflation measure—the headline PCE deflator—along with the eurozone’s preliminary August CPI, Tokyo’s August CPI, and Australia’s July inflation print. While these reports could introduce headline risk, central banks remain focused on data dependence. However, without a significant surprise, the current expectations for rate cuts are unlikely to shift dramatically. The pressing issue remains the aggressive rate cut projections priced into the market, coupled with an oversold dollar. Looking ahead, the next batch of economic data might reveal that July’s job losses and the rise in unemployment were somewhat exaggerated. Job growth could show sequential improvement, and the unemployment rate may dip. The August CPI, due on September 11, a week ahead of the FOMC meeting, could see the core rate inch higher.

United States of America

We are currently between the Jackson Hole symposium and the September 6 jobs report, with economists still adjusting their forecasts for Q3 GDP. The U.S. economy faces a critical juncture, where recent data and upcoming releases will shape expectations for growth, inflation, and Fed policy. With durable goods orders and personal consumption expenditures in focus, alongside the ongoing decline of the Dollar Index, market participants must remain vigilant for signs of shifting momentum.

Adjusting GDP Forecasts

As we move through the data cycle, GDP forecasts are still being fine-tuned. The Atlanta Fed’s GDP tracker is currently estimating Q3 growth at 2.0%, while Bloomberg’s survey indicates a median forecast of 1.5%. These early projections reflect the uncertainty surrounding key economic indicators and the evolving macroeconomic environment. This week’s durable goods orders report, for example, is expected to show a recovery of nearly 4% after a sharp 6.7% drop in June, driven by a surge in Boeing orders from 14 in June to 72 in July. However, excluding transportation, durable goods orders may have slipped by 0.1%, following a 0.4% rise in June.

The Role of Personal Consumption Expenditures

Personal consumption expenditures (PCE) play a crucial role in GDP calculations, and the better-than-expected retail sales report hints at a potentially larger gain than June’s modest 0.3% rise. Income growth is likely to have remained steady at 0.2%. While PCE deflators previously held significant market influence, the Fed’s recent shift in focus has reduced their impact. Fed officials are now more confident that inflation is on a sustainable path back to 2%, and the risks to their dual mandate have balanced out. As a result, the PCE deflator is less likely to spark major market reactions, especially after the release of CPI and PPI data earlier in the cycle. The headline and core PCE deflators are expected to rise by 0.2%, translating into small increases in the annual rates to 2.6% and 2.7%, respectively.

Anticipating the Jobs Report

Looking ahead to the August jobs report, early forecasts suggest job growth of around 155,000, compared to 114,000 in July. The unemployment rate, which has risen for four consecutive months through July, may dip slightly in August, potentially falling to 4.2% from 4.3%. This labour market data will be closely watched for signs of economic resilience or further softening, with implications for the Fed’s policy decisions.

Dollar Index Decline and Market Sentiment

The Dollar Index reached a new low for the year at the end of last week, dipping to around 100.60. Since early July, the index has steadily fallen from 106.00, with the latest leg down beginning on August 15 from above 103.00. This decline likely reflects the unwinding of large structured positions, and a corrective or consolidative phase appears increasingly probable. Momentum indicators suggest that the dollar may soon find support and begin to recover from oversold levels. Initial resistance is expected in the 101.60-102.00 range.

Key Points:

• GDP Forecasts: The Atlanta Fed projects 2.0% Q3 growth, while Bloomberg’s median forecast is 1.5%. Durable goods orders and PCE data will influence these projections.
• Personal Consumption Expenditures: PCE gains and steady income growth signal economic resilience, but the PCE deflator’s market impact has diminished as the Fed’s focus shifts.
• Jobs Data: Early forecasts suggest 155,000 jobs added in August, with the unemployment rate potentially dipping to 4.2%.
• Dollar Index: The Dollar Index has fallen to new lows, but a corrective phase may be approaching, with resistance seen around 101.60-102.00.

Australia

Reserve Bank Governor Bullock, once viewed as soft on inflation, has become one of the most hawkish figures in central banking since taking her post nearly a year ago. Her strong stance against rate cuts reflects the Reserve Bank of Australia’s (RBA) long-term view that inflation will not fall back into its 2-3% target range until late 2025. The upcoming economic data releases, including the July CPI print and retail sales, will be crucial in determining the trajectory of Australia’s economy and monetary policy.

Bullock’s Hawkish Shift

Initially considered dovish, Governor Bullock has solidified her position as a hawk on inflation, signalling to parliament earlier this month that it is too soon to consider cutting rates. The RBA’s inflation forecast remains cautious, with expectations that the inflation rate won’t settle back into the 2-3% target range until late 2025. Bullock’s concerns extend beyond inflation; she is wary that demand continues to outstrip capacity, further complicating the RBA’s task of balancing growth with price stability.

Upcoming CPI and Retail Sales Data

Early on August 28, the July CPI data will be released, a key metric for understanding the inflation trajectory. Inflation peaked at 8.4% in December 2022 but had fallen to 3.4% by the end of last year. After reaching 4% in May, the CPI slipped to 2.8% in June. However, the trimmed mean measure, a more stable indicator of underlying inflation, has remained above 4.0% throughout the second quarter. July retail sales data, due on August 30, will also provide insight into the strength of consumer demand. Retail sales rose by an average of 0.4% per month in the first half of 2024, compared to just 0.1% during the same period in 2023.

Market Skepticism and Rate Cut Expectations

Despite Bullock’s hawkish stance, the market remains sceptical. Futures markets continue to price in nearly a 90% chance of a rate cut by the end of the year and at least three rate cuts in 2025. This divergence between the RBA’s outlook and market expectations highlights the uncertainty surrounding Australia’s economic recovery and the challenge of containing inflation while supporting growth.

The Resilience of the Australian Dollar

The Australian dollar has experienced significant volatility amid global market turmoil. In mid-July, the Aussie was trading near $0.6800 before plummeting to the year’s low (~$0.6350) on August 5. However, it has since recovered, approaching $0.6800 again at the end of last week. While momentum indicators suggest that the currency is stretched, this does not rule out the possibility of further gains. The year’s high was set on January 2 near $0.6840, and a break below the $0.6700 area would be required to confirm a near-term top for the Aussie.

Key Points:

• Bullock’s Hawkish Stance: Governor Bullock’s transformation from perceived dovishness to hawkishness reflects the RBA’s determination to manage inflation, which may not return to the target until late 2025.
• Inflation Data: July CPI data is key to understanding inflation trends, with the trimmed mean remaining above 4.0% throughout Q2.
• Retail Sales: Retail sales data for July will be closely watched, having shown stronger growth in the first half of 2024 compared to 2023.
• Market Skepticism: Despite Bullock’s hawkish rhetoric, markets continue to price in a nearly 90% chance of a rate cut by the end of the year.
• Australian Dollar: The Aussie has rebounded from its August lows, with further gains possible if momentum holds, though a break below $0.6700 could signal a top.

Canada

Canada’s GDP Growth

Canada is set to release its June and Q2 GDP data, with growth expected to come in close to the Q1 annualized rate of 1.7%, though slightly slower. Given these expectations, any significant market impact will likely only occur if the data deviates substantially from forecasts. The focus remains on the economy’s steady progress amid global uncertainties. While the economy’s growth pace may have slowed, it remains resilient, and markets are not bracing for any surprises from the upcoming GDP report.

Subdued CPI and Rate Cuts

Last week’s subdued CPI data seemed to validate the market’s expectation for a rate cut at the September 4 Bank of Canada meeting. This anticipated cut will mark the third in the current cycle, with markets already pricing in at least two more cuts by the end of the year. The relatively low inflation pressures allow the Bank of Canada room to manoeuvre aggressively with its monetary policy without significantly disrupting the economy. The central bank’s rate-cutting trajectory, among the most aggressive in the G10, reflects its efforts to stimulate growth while balancing inflationary concerns.

The Canadian Dollar’s Resilience

Despite the front-loading of rate cuts, the Canadian dollar has demonstrated resilience, even falling below its 200-day moving average without suffering a significant decline. The fact that the exchange rate has not been adversely impacted by these aggressive rate cuts provides the Bank of Canada with greater confidence to proceed with further easing measures. The currency’s stability underlines the market’s confidence in Canada’s economic fundamentals and the central bank’s strategy.

Canadian Dollar’s Performance

The Canadian dollar experienced its best day of the year last Friday, gaining 0.75%, which contributed to a 1.25% increase for the week—the strongest weekly performance in 2024. The U.S. dollar, which hit its yearly high of CAD1.3945 on August 5, tested the CAD1.35 level before the weekend. April 4 was the last time the U.S. dollar traded below CAD1.35, and a break below this key level could lead to a swift move toward CAD1.3450.

Key Points:

• GDP Growth: Canada’s Q2 GDP is expected to closely mirror Q1’s 1.7% annualized rate, with little market impact expected unless there is a significant surprise.
• Rate Cuts: The Bank of Canada is set to implement its third rate cut in the current cycle on September 4, with two more cuts anticipated by the end of the year.
• Currency Resilience: The Canadian dollar has remained strong despite the aggressive rate cuts, reinforcing the Bank of Canada’s comfort in easing policy further.
• Currency Outlook: The Canadian dollar’s recent strength, especially against the U.S. dollar, suggests a potential move below CAD1.35, although stretched momentum indicators may temper expectations of further gains in the short term.

Europe

Eurozone CPI Outlook

The highlight for the Eurozone this week is the preliminary August CPI report, which is expected to show a small decline in the year-over-year rate. In July, CPI stood at 2.6%, and with the August 2023 0.5% increase set to drop out of the 12-month comparison, it will likely be replaced by a smaller 0.2%-0.3% increase. For the past six months, the Eurozone CPI has fluctuated between 2.4% and 2.6%, and it appears poised to remain in that range for the time being. Despite this stability, the market is convinced that the European Central Bank (ECB) will cut rates at its September 12 meeting, with another cut anticipated before the end of the year. The swaps market has already priced in 70 basis points (bp) of cuts by year-end, reflecting the strong expectation of further easing.

ECB Rate Cut Expectation

The ECB’s stance on monetary policy continues to dominate market sentiment. Despite inflation remaining stable within the 2.4%-2.6% range, the market’s confidence in rate cuts reflects broader concerns about economic growth and the ECB’s focus on stimulating activity. With 70 bp of cuts discounted by the end of the year, the market is positioning for a more dovish ECB in the months ahead.

US-German Yield Spread

The US two-year Treasury yield premium over Germany has fallen below 155 bp, a level not seen since May 2023. This narrowing spread reflects shifting expectations about monetary policy in both regions, with the ECB expected to ease further, while the Federal Reserve remains cautious about rate hikes. If the spread continues to tighten, it could have implications for currency markets, particularly for the euro against the US dollar.

Euro’s Performance and Outlook

The euro set a new high for the year last week, reaching $1.12. However, despite this momentum, caution is warranted. The risk-reward balance suggests that chasing the euro higher before a corrective phase could be risky. A corrective pullback appears likely in the run-up to the US employment data on September 6. During this period, the euro could fall into the $1.1000-$1.1050 range, offering a reasonable magnitude for an initial correction. With momentum indicators not yet turning, this correction could provide an opportunity for the euro to consolidate before attempting another move higher.

Key Points:

• CPI Data: Eurozone’s August CPI is expected to show a slight decline, maintaining the year-over-year rate within the 2.4%-2.6% range.
• Rate Cut Expectations: The market is pricing 70 bp of ECB rate cuts by the end of the year, starting with a cut at the September 12 meeting.
• Yield Spread: The US-German two-year yield spread has narrowed to below 155 bp, reflecting shifting expectations for monetary policy in both regions.
• Euro Outlook: The euro reached $1.12 but is poised for a corrective phase, with potential support in the $1.1000-$1.1050 range ahead of US employment data on September 6.

Japan

Japan’s Monetary Policy and Economic Data

The Bank of Japan (BOJ) seems determined to continue normalizing monetary policy, but external shocks, such as the recent stock market crash, have made it cautious. Despite this, Japanese investors have capitalized on the yen’s strength to purchase foreign assets, particularly bonds. Domestically, the equity market has stabilized, with the Nikkei rallying nearly 24% from the panic lows on August 5. The Topix has also recovered, retracing almost two-thirds of its losses from its multi-year high on July 11. The swaps market is reflecting this confidence, pricing in slightly more than 11 basis points of tightening by the end of the year—a new high for the BOJ’s outlook.

Key Economic Indicators

Japan’s upcoming economic data releases include unemployment figures, retail sales, industrial production, and Tokyo’s August CPI. The unemployment rate was steady at 2.6% from February through May before slipping to 2.5% in June, a level not seen since the pandemic. Retail sales grew every month in Q2, with a year-over-year increase of 3.7% in June, the highest since February, possibly buoyed by rising wages. However, household spending, reported in real terms, has been contracting since November 2022, except for two months (April 2024 and February 2023). In GDP terms, consumption fell for four consecutive quarters before finally rising in Q2 2024.

Meanwhile, industrial production in Japan experienced a sharp decline in June, falling by 7.9% year-over-year—the largest drop since September 2021. Monthly, industrial output fell by 4.2%, erasing the 3.6% increase recorded in May. The most market-sensitive data point will likely be Tokyo’s August CPI, which usually serves as a strong indicator of the national CPI, similar to the eurozone’s preliminary estimates. Tokyo’s headline and core CPI were both at 2.2% in July, and are expected to remain close to that level in August. The headline CPI peaked at 3.9% at the end of 2022, while the core CPI hit 4.3% at the start of the year, suggesting that inflationary pressures have moderated but remain a key factor for the BOJ’s policy decisions.

Yen’s Outlook and US Interest Rates

The future direction of the yen appears to be more influenced by US interest rates than domestic factors. Last week, the yen strengthened, and the dollar closed near JPY144, pulled lower by the drop in US Treasury yields. The 10-year US Treasury yield settled around 3.80%. If the dollar breaks below JPY144, it could test the August 5 low near JPY141.70. On the other hand, initial resistance for the dollar may be found in the JPY145.00-JPY145.50 range, which could challenge the yen if US yields recover.

Key Points:

• Monetary Policy: The Bank of Japan is expected to continue normalizing policy, with the swaps market pricing in more than 11 basis points of tightening by year-end.
• Economic Indicators: Unemployment, retail sales, and Tokyo’s CPI will provide key insights into Japan’s economic trajectory. While inflation has moderated, it remains a central concern.
• Industrial Production: Japan’s industrial output fell sharply in June, reversing gains made in May, which could impact future economic projections.
• Yen Outlook: The yen’s near-term movement will likely be driven by US interest rates. A break below JPY144 could see the yen test JPY141.70, while resistance is expected around JPY145.00-JPY145.50.

United Kingdom

Bank of England and Rate Cuts

Among the G7 central banks, the Bank of England (BoE) is one of the few that may not cut rates in the upcoming month. However, before the year ends, the swaps market is pricing in the possibility of two rate cuts in the current cycle, with around an 80% chance of a third cut. This reflects the growing anticipation of easing despite the BoE’s cautious approach in the short term.

Sterling’s Strong Performance

Sterling has emerged as the best-performing G10 currency this year, gaining 3.7% against the US dollar and 2.4% against the euro. This strong performance contrasts with other G10 currencies, which have seen more modest movements or declines. Sterling’s resilience reflects the relatively stable economic conditions in the UK and favourable market sentiment.

Sterling’s Recent Rally

Last week, Sterling experienced its best week of the year, rising about 2.0% and reaching levels last seen in Q1 2022, peaking at around $1.3230. Since the August 8 low, Sterling has appreciated by more than 5.5 cents, falling in only one of the past 13 trading sessions. Despite stretched momentum indicators, Sterling closed the week on a strong note. The next significant resistance level is in the $1.3300-$1.3330 range, with initial support around $1.3130.

Key Points:

• Bank of England: The BoE may not cut rates next month, but two cuts are expected by year-end, with an 80% chance of a third.
• Sterling Performance: Sterling is the best-performing G10 currency in 2024, with notable gains against both the US dollar and the euro.
• Sterling Outlook: Sterling may test the $1.3300-$1.3330 range, with initial support around $1.3130.